Foreword by Andrew Chilvers
For ambitious companies eager to expand into overseas markets, often the conventional route of organic business development is simply not fast enough. The other option to invest in or buy a business outright is far quicker but often fraught with unforeseen dangers. And even the biggest, most experienced players can get it badly wrong if they go into an M&A with their eyes wide shut.
If you search for good and bad M&As online the Daimler-Benz merger/acquisition with Chrysler back in 1998 is generally at the top of most search engines on how NOT to undertake a big international merger. Despite carrying out all the necessary financial and legal measures to ensure a relatively smooth deal, the merger quickly unravelled because of cultural and organisational differences. Something that neither side had foreseen when both parties had first sat down at the negotiating table.
These days the failed merger of the two car manufacturers is held up as a classic example of the failure of two distinctly different corporate cultures. Daimler-Benz was typically German; reliably conservative, efficient, and safe, while Chrysler was typically American; known to be daring, diverse and creative. Daimler-Benz was hierarchical and authoritarian with a distinct chain of command, while Chrysler was egalitarian and advocated a dynamic team approach. One company put its value in tradition and quality, while the other with innovative designs and competitive pricing.
Torben Welch discussed The Art of Deal Making: Using External Expertise Effectively as part of the Real Estate chapter
How important is local market intelligence to effective cross-border real estate transactions, in your view, particularly in the current Covid-19 market? Any examples of how you have helped clients using expert insight into your jurisdiction’s real estate market?
Local market intelligence is crucial to enable the prospective purchaser to gather information and determine whether or not a specific asset – or even the geographical location – is valuable to the company’s goals. A local real estate agent and attorney who has previously worked on assets in the area is important to acquire such information that will make an acquisition viable.
This information gathering is most effective before negotiations with the other party begin. It is important that the prospective buyer asks its agent to go beyond the typical “sales” function in a transaction and assist in collecting as much information as possible about the asset: tenant mix, parking issues, deed restrictions or covenants, etc. An agent should be able to provide valuable insight as to whether or not an asset is underperforming or defective in some way and explain why a national tenant may have chosen a different site over this one.
However, reliance solely on a real estate agent in such pre-contract phase is misguided. Critical aspects of local market intelligence (including the impact local building, zoning and codes, operating ordinances, deed restrictions or covenants, etc.) are often missed or overlooked in the pre-contract phase. This will save significant amounts of cash and time that may needlessly be expended once the asset is under contract. On several occasions, clients have approached me to conduct a preliminary review or public record documents and related information. In doing so, we have discovered long-standing title defects that are not correctable or restrictions that would render the property unfit for the client’s intended use. By spending a little bit of time early on, the client was able to avoid a significant waste of time and resources that would have been devoted to the contract process.
What are some of the key elements involved in achieving an accurate valuation for a real estate portfolio prior to the deal making process?
Value is king in real estate deal-making. A standard industry practice to determine value is the appraisal, which attempts to value an asset. In most cases, the appraisal is viewed by a prospective purchaser as the way to convince a lender to utilize the asset as collateral for the acquisition price. But appraisals often fail to address non-quantitative aspects of the asset that may make it more valuable to the buyer.
Nevertheless, the standard appraisal should be viewed as an estimate of value that could be correct so long as certain assumptions remain. A wise buyer uses the real estate appraisal as a starting point to drive business decisions about whether the acquisition is in the company’s best interests. That the appraisal supports the valuation the lender is looking for may not make the asset truly valuable to the buyer.
Buyers should identify aspects of the asset that will add value to the company’s business and not to the asset: is the location close to the buyer’s suppliers, vendors and customers? Is there sufficient square footage to relocate several operations which will reduce overheads and increase cash flow? Are overall acquisition costs low, which will net some equity that can be utilized in a refinance across the portfolio in the future? Are there adjacent parcels that may be available to acquire in the future? Is there a tenant that will take possession of the space that makes the valuation ideal?
A buyer must look at these items in addition to an appraised value to determine whether or not valuation is accurate. If a buyer asks “how does this asset increase the value of my business?” instead of “is this appraised value accurate?” then the buyer can better
assess the risk of the acquisition in relation to the company’s overall goals.
What Tax-Efficient Vehicles Can Be Used To Hold Real Estate In Your Jurisdiction? Any examples of deals you have structured in this way?
There are a variety of entities in which to hold real estate, some of which are designed to limit liability (limited liability companies, series limited liability companies) and others that are designed to maximize tax benefits for investors by controlling how income from the properties are treated (i.e. earned, investment or passive income – each of which are taxed differently). Generally speaking, most real estate assets will be held in a separate special purpose entity formed as either a limited liability company or an s-corp, which is a corporation whose income is passed through to the individual shareholders for tax purposes.
Regardless of the type of entity structure, tax deductions available to business and real estate owners have been the principal way to lower taxable income related to the asset. These deductions include property taxes, property management fees, capital improvements, etc. Furthermore, certain economic conditions can likewise create passive losses which are deductible.
Top Tips – To Optimize a Real Estate Portfolio
- Have a Plan. Understand what types of real estate fit into your entities’ core strengths and seek properties that match that. For example, if your internal operations are streamlined to handle multiple tenants, a few large warehouse buildings with single tenants may create excess internal operation expenses.
- A “good deal” doesn’t necessarily mean “low price.” Ensure you are evaluating aspects of the property beyond the price. Research the asset before starting negotiations – check tenant mix, parking regulations, tax status, etc. Ensure there are termination rights during the due diligence period. Ask questions of the property manager.
- Be forward thinking. Treat real estate assets as a true asset that can be traded when necessary. Keep your eye on the “flip” – does the property have characteristics that a future buyer will want? If the market adjusts, will the property still have value that can easily be sold?